Thursday, July 9, 2015

The Economics of George Orwell, Not

   Roger Farmer has a couple of provocative    
   posts on behavioral economics.  The first   
   is entitled "The Economics of George 
   Orwell," where Farmer offers two 
   criticisms of behavioral economists such 
   as Richard Thaler, George Akerlof, and 
   Robert Shiller:

1. “Behavioural economists assert that what makes individuals truly happy can be different from what they in fact choose to do. In Akerlof and Shiller’s words, ‘...capitalism...does not automatically produce what people really need; it produces what they think they need...’ (p. 26).”  From these assumptions, it’s pretty easy to draw paternalistic conclusions, which lead, not to happier people, but towards Orwell’s 1984 dis-utopia; and

2. Neoclassical economics doesn’t need behavioral psychology. Instead Farmer insists, “we can understand all of the failures of classical macroeconomics without giving up on rational choice.”

Leaving Farmer’s second proposition for a future post, I do want to say something about “classical liberalism,” an outlook affirmed by Farmer and well-expressed in his critical reaction to the very idea that someone could know a person’s “true preferences” better than the person, himself, does.  

Consider one of the most effective “nudges” emerging from behavioral economics – changing the default option for employee contributions to a deferred income account from zero to, say, 5%.  In other words, instead of requiring employees to “take action” in order to defer income, they now have to “take action” to avoid deferring income.  Does this change in the default option assume that policymakers know more about employee preferences than the employees themselves do?

Not necessarily.  Suppose there’s lots of research showing that a great many middle-age workers either haven’t done any retirement planning or have wildly optimistic forecasts of their income in retirement.  By “wildly optimistic,” I mean forecasts that would be rejected by, say, 95% of certified financial planners.  So, in this case, the policymakers aren’t substituting their (assumed) preferences for “less current income and more future income,” rather they are assuming that if employees had reasonable forecasts of their own retirement income, many of them would choose to defer some their current income.

Farmer says, “The idea that the government knows my preference better than I do is a little too Orwellian for me.”  I think it’s worth distinguishing between “ill-informed” and “well-informed” preferences.  Granted, this distinction can become a pretext for paternalism.  But, in the case at hand, no one is compelling employees to save more.  Requiring employees to “check a box” to opt out of a deferred income plan doesn’t really qualify as “Orwellian,” particularly when some sort of default option is required in any case. 

The fact that a significant number of employees began to defer some of their income when deferral became the default option raises another, deeper question about Farmer’s classical liberalism, namely how do our preferences arise, persist, and change over time?  Can anyone really believe that capitalism always produces “what people really need”?  Farmer’s models include profit-maximizing firms.  Are we to assume that producing “what people really need” is always more profitable than creating new “needs”?  Should we assume that the $180 billion U.S. firms spent on advertising in 2012 merely conveys information to the public?

It’s not just advertising that shapes our preferences, but rather the whole culture.  Farmer seems to think that we freely choose our preferences, and he worries that if “the form of the utility function is influenced by 'persuasion', then we lose the intellectual foundation for much of welfare economics.”  Insofar as this “intellectual foundation” includes the conception of “preference” Farmer seems to have in mind, it has already been subjected to withering criticism by Amartya K. Sen and others (see especially Sen’s well-known papers, "Rational Fools" and "Behavior and the Concept of Preference").

Saturday, January 24, 2015

Is Continuous Market Clearing a Good Premise for Macroeconomic Modeling?

I haven’t quite finished Kartik Atherya’s book, Big Ideas in Macroeconomics, but one proposition, in particular, seems implausible to me, and that’s Kartik’s claim that real world markets are very similar to a "Walrasian central clearinghouse."  In short, real world markets operate as if they were run by an auctioneer who's continuously finding the prices at which supply and demand are equal.

Just for the fun of it, I decided to explore the prices at which Big Ideas in Macroeconomics was being offered on  All the prices I recorded were for a new copy of the book and include the cost of standard shipping.  The chart below displays the offer price for Big Ideas and the "percent favorable ratings" for 23 sellers.  I’ve excluded one Amazon Prime offer because Amazon Prime membership costs $72, and provides free two-day shipping among other benefits.

Here are a few statistics from this single day on Amazon: 1) the mean price of Big Ideas was $49.65; 2) the lowest price was $23.99; 3) the highest price was $75.81; and 4) the standard deviation was $14.07.  (The Amazon Prime price with free two-day delivery was $35.11, but isn’t included in the chart). 

My question is: if this online market is like a Walrasian clearinghouse, how can we explain the wide dispersion of prices for this standardized item?  One possibility is that suppliers with good reputations (high favorability ratings) might be able to charge a higher price because buyers have more confidence that the book will be delivered on time.  As it turns out, the opposite is the case: lower prices are correlated with higher ratings.  

This pattern of prices is not what one would expect if actually resembled a Walrasian central clearinghouse.  Now it might be objected that the “higher” prices don’t really “count” because few transactions will take place at these prices.  Perhaps, but if so, why do "high-price" dealers bother to post a price at all?  Since anyone can find out what prices are being offered on Amazon, why would a bookseller who saw ten offers at $50 or less decide to offer the same book for, say, $65?

I’m open to other explanations, but my tentative conjecture is that, which typically has a wide range of prices for identical items, doesn’t look like a Walrasian market at all.  And if doesn’t fit the bill given all of its apparent market-like virtues, then how many other markets depart from the ideal?  

Monday, January 19, 2015

Are we all Friedmanites now?

Paul Krugman started an interesting debate (here) by claiming there are no serious conservative economists who are also public intellectuals.  The left has Nobel laureates Joseph Stiglitz and Krugman himself.  The right is stuck with Arthur Laffer and Stephen Moore.  Nick Rowe followed up (here) by claiming that the Great Economic Debate had already been won when Milton Friedman made mincemeat out of John Kenneth Galbraith.  Rowe concludes with this:

“The right won the economics debate; left and right are just haggling over details. The big debate is no longer about economics (sadly for me); and it won't be held on the pages of the New York Times or in the economics journals.”

This just seems incredibly wrong.  To begin with, there's no consensus among economists which would support the claim that the debate is over and "the right won."  The fact that a liberal like Brad Delong approvingly cites Friedman from time to time doesn't mean "we're all Friedmanites now."  Even if Friedman won his debate with Galbraith (JKG), "the right" would only be the ultimate victor if JKG were the sole leftist engaged in the argument.  He was not.

Galbraith once said, “Milton Friedman's misfortune is that his economic policies have been tried,” and, one could add, his theories have been tested too.  Let’s begin with Friedman’s monetarism and PQ = MV.  Assuming V is stable and M is exogenous, then the Quantity Theory is resurrected.  But V is not stable.  If it were, quantitative easing would have produced a lot more inflation than it has.  And as Nicholas Kaldor pointed out a long time ago, Friedman's equation can also be read from left to right, with MV adapting to PQ as in endogenous theories of money.  (Kaldor’s little book, The Scourge of Monetarism here, is a minor masterpiece of deconstruction.)

Friedman’s permanent income hypothesis is an important idea, but Friedman wasn’t its sole creator, nor is it an infallible guide to policy.  Perhaps a third of U.S. households live hand-to-mouth.  They spend their whole paychecks and probably spent the lion's share of their one-time stimulus checks from the Treasury. Imperfect capital markets make consumption smoothing very difficult for lower income households.

Friedman's plan for privatizing social security was implemented in Chile many years ago.  If you’re interested in the results, you’ll find Peter Diamond’s comparison of Chile’s system with the U.S. system instructive (here).  It does not favor the privatization manifesto.

Rowe mentions school vouchers as a winning Friedman formula, but here, too, the record is less clear than fans of the approach advertise.  One problem is that vouchers drain active parents from low-income schools, leaving the remaining students worse off.  This isn’t to say vouchers aren’t good for the parents and students who take advantage of them (though this too is questionable), but proponents ignore its adverse selection side effects.

Friedman's Essays on Positive Economics remain authoritative for many contemporary economists.  But positivism has long been in decline among philosophers like Hilary Putnam, and philosopher-economists like Vivian Walsh and A. K. Sen.  Their recent book, The End of Value-Free Economics, is a good antidote to Friedman.

Nick mocks Galbraith's concern with monopoly power, wage and price controls, and other "daft" ideas of the 1970s.  But, let us ask, was JKG's stress on the divergence between private luxury and public squalor in “The Affluent Society” not instructive?  Was his emphasis on the state's role in serving the interests of large corporations in “The New Industrial State” really off the mark?  Is perfect competition a more relevant model than imperfect competition?  Does the massive infrastructure of "advertising" not have a deep and wide-ranging impact on our way of life, not to mention on our "wants" and "needs"?

It's easy enough to say, "the debate is over, and our side won," but saying so doesn't make it so

Thursday, July 10, 2014

Some Post-Keynesian Suggestions for Brad DeLong

G.L.S. Shackle
Commenting on a Lars P. Syll post, Brad DeLong  grants that there may be something profound in the Post-Keynesian view that neither market participants nor economists “know the data-generating process.” “OK,” Professor DeLong allows, “suppose we decide to give up” this assumption, “what do we then do - what kind of economic arguments do we make – once we have made those decisions?"
I have a few suggestions, but first let’s be more specific about the Post-Keynesian complaint.  There is no “data-generating process” if, by this, Brad means a stationary, ergodic process (See P. Davidson, John Hicks, and even K. Arrow). (For reference, here’s Wikipedia’s definition of “ergodic”: “A stochastic system is called ergodic if it tends in probability to a limiting form that is independent of the initial conditions”).
More generally, the application of the probability calculus to the behavior of market participants isn’t wholly satisfying (See J.M. Keynes [weight of an argument], G.L.S Shackle [conceptual deficiencies of the probability calculus], and Taleb [Black Swans and Fat Tails]).
If one accepts these skeptical propositions (at least provisionally), then the following analytical suggestions seem worthy of consideration.  (I offer these without explanation, hoping the connections aren’t too hard to figure out):
1. “History” should take its place alongside “Equilibrium” in economic modeling and argument;
2. Hysteresis isn’t an “add-on."  Many (maybe even most) real-world outcomes are path dependent;
3. Disequilibrium is the normal state of the “macroeconomy,” the ex post accounting world rarely corresponds to the ex ante expectations that produced it, and you can't ignore "out-of-equilibrium behavior";
4. Agent-based modeling (Santa Fe style) may prove useful in thinking about interactions among agents with different “views of the world,” the bulls and the bears, etc.;
5. Leave Tobin’s “Liquidity as Behavior Towards Risk” aside in favor of G.L.S. Shackle’s analysis of the elemental need that’s satisfied by money in a contemporary economy the future states of which can’t be known today; and

6. Coordination problems are important (if there are no rational expectations to replace the missing futures markets of Arrow and Debreu).

Tuesday, July 8, 2014

Kenneth Arrow on Some "Big Ideas in Macroeconomics"

What’s the significance of Arrow & Debreu’s canonical article, “Existence of an Equilibrium for a Competitive Economy” (1951)?  According to one school of thought, which is well summarized by Kartik Athreya in Big Ideas in Macroeconomics (2013), Arrow-Debreu (and McKenzie) is the “bedrock” on which mainstream macroeconomics has been constructed.  The implicit premise of this body of work, which, on Athreya’s view, includes the best of both New Classical and New Keynesian Economics, is that real-world economies can be usefully modeled within a general equilibrium framework in which all markets clear.

According to a different school of thought, however, Arrow-Debreu is more profitably understood as a compendium of the stringent conditions that must be satisfied if, as Arrow’s collaborator, Frank Hahn put it, there are to be no “Keynesian problems.”  Although this latter scheme of thought seems to have petered out (Hahn isn’t even mentioned in Athreya’s book), it’s nevertheless an avenue worth exploring.

Kenneth Arrow, himself, has been asked on several occasions about the scheme of thought described in Athreya’s book.  In 1995, in an interview conducted at the Federal Reserve Bank of Minnesota, Arrow was asked whether he was surprised by the advances made by New Classical economists who were “greatly influenced by your [i.e., Arrow’s] work in the 1950s in general equilibrium.”  Arrow replied,

“The vision I had that wasn't articulated in my articles exactly was that the macroeconomy was the disequilibrium phenomenon. The idea that we could interpret economic fluctuations as an equilibrium phenomenon was something that did not cross my mind. And I'm still not sure that the disequilibrium interpretation isn't more appropriate, although much more has been gotten out of this equilibrium theory than I would have ever dreamt.”

More than a decade later, in an interview published in MPRA (2005), Arrow was asked about a forthcoming article in the Journal of Political Economy, "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis," by Harold Cole and Lee Ohanian, which argues that large fluctuations, like the Great Depression, may be the result of poor policy in a general equilibrium framework.  Arrow’s response,

“Do you know their explanation for depression? That the total factor productivity in 1932 was 24% lower, so they say, than it was in 1929. That's what explains the depression, as they see it. In their model, that drop in productivity is exogenous. In my book that's not an explanation.”

Ohanian applied the same general equilibrium model to explain the Great Recession in the U.S., though in this case the culprit isn’t a decline in total productivity, but a decline in hours worked, which Ohanian attributes to a sudden increase in the marginal value of leisure relative to the marginal product of labor, leading to a voluntary reduction in hours worked.  Perhaps Arrow would now find this “equilibrium” approach more congenial, but in 1995, he said,

“I do think the interpretation of unemployment specifically is not well represented in the equilibrium models. I don't believe that unemployment is all voluntary, by anticipation of future wage movements or this sort of thing. I know you can modify the models by taking into account the indivisibilities, but I don't really think that people are voluntarily unemployed. When a job is offered, not so much today but say a few years ago, you would have had many applicants for it--people who do not seem to be conspicuously differently qualified than those who are now working.”

Of course Arrow doesn’t get the last word on whether “Minnesota macro” rests comfortably on the foundations of Arrow-Debreu.  But readers of Athreya’s Big Ideas in Macroeconomics and Stephen Williamson’s blog, where Big Ideas was recommended, should be aware that some very good economists have drawn quite different lessons from Arrow & Debreu’s ingenious conception of general equilibrium.